Friday, December 02, 2005

VCs and investing in "me-too" companies

John Cook at the Seattle PI talks about how VCs seem to trend follow, throwing money at startups with many existing venture-backed competitors:
VCs are investing in startup companies that already have four or five venture-backed competitors -- something I saw during the dot com boom of the late 90s and something that is occurring once again ...

Rustic Canyon Partners' Jon Staenberg said he is concerned about the "me-too" companies being formed in certain sectors. He said the world didn't need five or six online pet food stores during the late 1990s and it probably doesn't need five or six social networking companies today.

Some carnage will occur.
From my experience talking with VCs over the last couple years, I think VCs invest in "me-too" companies because there is less personal risk for them to do that than find and invest in new ideas.

Look at it from a VC's point of view. You have one company is entering a market space that several other VC firms have evaluated and blessed. Another company has a new product that has no market history, requiring a lot of effort to evaluate the potential.

Arguing for investing in the first company is easy. Just point at all the other interest and the due diligence the other firms presumably already did. If the company fails in the end, you can say, "Well, everyone thought this was a good idea. Not my fault."

Championing the second company is personally risky and hard. Due diligence on a new technology requires a lot of expertise, time, and work. In the end, a couple people at the firm will have to stick their necks out on the investment to get the other partners to go along, something that is personally risky for them if the investment fails.

While this may not be the best thing for the investors in the fund, the VCs are just behaving as rational actors, minimizing their personal risk. "Me-too" trend following is the result.

[I first posted a version of this as a comment on John's post. I later decided to cross-post it here.]

1 comment:

Naval said...

Greg, I don't think it's that simple. To view something as overcrowded, you'd have to divide the potential market size by the number of competitors. People simplistically seem to assume that 5 companies is too many. Is that true in the offline world? Is that true in e-commerce? Why should it be true in search, news, travel, or other multi-billion dollar industries? However, I grant you that certain narrow sectors get over-crowded due to the effects that you mention.